How does payment in advance work?
Boosting your income is the key to keeping your cash flow positive. The higher your cash inflow, the easier it is to invest, settle your bills on time, and maintain vendor relationships.
But what if the money exiting your business seems to be more than what you're bringing in?
Enter advance payment. You can use it for new customers or those with late payment history. But remember to account for this revenue to the last euro. That way your accounting stays intact and your books balanced.
Let's dive deeper into what advance payment is, how you can account for it, and its pros and cons.
What does payment in advance mean?
Payment in advance is a type of payment where a customer pays you for goods or services before receiving them. This revenue can be a total lump sum, a down payment, or a partial amount.
The actual advance payment amount depends on a few factors:
Cost fraction associated with materials buyouts
Client's payment history
Advance payments act as a cover against risks related to nonpayment. And as pandemic-induced financial uncertainties continue to haunt the world, advance billing is now a trend. It can offer you quick cash to settle current demands and expenditures.
You can require upfront payment exclusively or in special circumstances, such as:
When a customer has a bad credit history and extending credit to them would attract a liability
To cover a project's material costs
To reduce or insure yourself against the risk of nonpayment for larger orders
When you have a limited product capacity
When you've custom-made a product for a particular customer
When the client asks to pay in advance, which may happen if they use cash-basis accounting
Examples of advanced payments
Paying a deposit to an external website developer before they create your site
Paying quarterly or yearly subscription for a streaming service
Paying a retainer to your solicitor
Credit card prepayments
How payment in advance works
First, estimate the product's or project's budget. Be as accurate as possible – you don't want to overcharge your client.
Record the transaction once you invoice the client and get the upfront amount. Once again, accuracy is still crucial.
How to account for advance payments
It's important to account for all revenue you receive in advance. Here are the steps:
First, what type of advance payment is it? That depends on whether or not you've delivered the products or services.
Earned revenue: The payment for products you've delivered to the customer but that have not yet been invoiced.
Unearned revenue: The payment for products or projects you'll complete and invoice at a future date. Here, the buyer hasn't yet received the goods/services.
Next, establish your deferred revenue account. Remember that your buyer's down payment isn't straight revenue – it's a liability to you.
Third, associate the payment to the right client account. Be sure you've created an account for each new buyer. You should then record the earned and unearned payments in that account.
2. Account for the upfront amount
According to the accrual accounting method, you should report unearned income as a liability. So list any advance payment received within a year as a current liability:
Debit your cash account
Credit the liability (customer deposits) account in the same amount as the advance
Just a reminder: debits increase assets, expenses, and dividend accounts. On the other hand, credits reduce these accounts and increase equity and liability accounts.
After completing a sale or project, send your customer an invoice that includes what they owe you currently (total payment minus down payment).
Revenue recognition occurs when you've fully delivered the project and invoiced the customer, not when you've received the money.
Credit the revenue account
Debit accounts receivables
Debit the liability (customer deposits) account
Depending on the type of advanced payment, report it on your income statement or balance sheet as follows:
Unearned income: Report it on the balance sheet.
Earned income: Post it on your income statement once you've sent an invoice.
Once you've invoiced the customer, report the invoice to the appropriate records. This moves the unearned revenue from the balance sheet because you can now link it directly with an invoice number you allocated to the client's account. Similarly, move earned revenue on the income statement against the invoice.
Why is accounting for advance payments necessary?
Advance payments can increase your revenue and ensure that the expenses of delivering a product don't hurt your profit margin.
But you should account for all these payments properly to avoid confusion. Unfortunately, it's hard to catch up with poor accounting retroactively.
Advantages and disadvantages of advance payments
Your business can benefit from prepayments. But this billing type also comes with some disadvantages.
You rarely need to chase payments
Minimal risk of loss, as you can fund the project upfront
You can account for the project's income and costs in the same timeframe
Maintaining cash flow consistency is a breeze
Simplifies automation of invoices
It may seem unusual to a new customer
Reimbursement is more complicated
If a project's scope changes, you'll have to apply the changes to the next invoice
Advance payments and payment processing
Advance payments can help reduce the risk of delivering products or services without getting paid, as your customer can pay for goods and services upfront. This can help you to always have a steady inflow of working capital, but you need to make sure to account for all the prepayments and full cash correctly.
Keep your reputation intact, and more customers will feel confident paying you in advance. Just make sure to offer a robust system to make advance payment seamless for them.
Grow your way with Mollie
At Mollie, our aim is to provide effortless payments to help you grow your business with ease. That includes helping you offer your customers a seamless checkout experience optimised for conversion. We also offer a range of payment features and leading and localised payment methods to drive growth.
Discover more about payments with Mollie.